Greenspan in a Bind

His efforts to revive the economy have failed to do the trick

September 3, 2001, 12:00 AM EDT

Back in January, when Federal Reserve Chairman Alan Greenspan launched the central bank on its most aggressive interest-rate-cutting campaign in nearly 20 years, the decision was in many ways an easy one. The high-flying New Economy had ground to a halt. Stock prices were plunging. And consumers were growing more worried by the day. What was needed, clearly, was a heavy dose of monetary medicine to stave off a recession. Dr. Greenspan provided that, cutting rates seven times in eight months.

But now, a full three percentage points of rate reductions later, Greenspan finds himself in a bind. His all-out effort to turn the economy around so far has not done the trick. The U.S. is still teetering on the edge of a recession, and deflationary forces are mounting. The stagnant economy is also taking its toll on corporate profits. On top of all that, the once-ballooning federal budget surplus has collapsed, a victim of the Bush tax cuts and a slowing economy. On Aug. 22, the White House said that this fiscal year's non-Social Security surplus would fall to less than $2 billion--down from a $125 billion surplus projected in the Bush Administration's April budget request. "There are a lot of negative things around," says W. James Farrell, CEO of Illinois Tool Works, a diversified manufacturer in Glenview. "I don't think the odds are good that the economy's going to go back up."

The trouble, experts say, is that the Fed is increasingly constrained in how much more it can do to combat the economic weakness. Another round of rapid-fire rate cuts could turn what so far has been a welcome, gentle fall in the dollar into a full-scale rout. "If the dollar continues to weaken, the Fed's hands could be tied when it comes to further easing," says Michael Wallace, a senior economist at Standard & Poor's, which like BusinessWeek is a unit of The McGraw-Hill Companies.

Further aggressive monetary easing also runs the risk of pumping up already frothy house prices, setting the stage for a damaging downturn later on. Housing prices nationwide are rising at a more than 8% annual clip, with some cities, such as Washington, registering double-digit gains. "Home buyers are taking note, preferring to invest in housing rather than in the declining stock market," says Bruce Smith, a builder in Walnut Creek, Calif.

It's sentiment such as this that has some analysts worried. They fret that ebullience in the housing market may reflect too-loose credit standards by mortgage lenders. The result, these analysts say: House prices have reached bubble status in some parts of the U.S.--a worrying trend that would only be exacerbated by bigger Fed rate cuts.

ANTSY CEOs. Faced with the conflicting pressures, Greenspan has ratcheted back on the size and frequency of the Fed's rate cuts. The central bank's quarter-point reduction on Aug. 21 was its second bite-size cut in three months, following five rapid-fire reductions of a huge half-point each earlier in the year. In a statement announcing its action, the central bank signaled that it might cut rates again but was in no hurry to do so. Wall Street turned thumbs down on this scenario, sending stocks into a downward spiral before they recovered partially the next day.

Investors are worried that the Fed's more languorous approach to rate cuts could undermine the much-hoped-for economic recovery before it fully gets under way. With the long-awaited second-half rebound proving elusive so far, business leaders and investors are getting antsy about a continuing disinflationary business downturn that's eating away at corporate profits. With their selling prices under pressure from fierce competition and a dearth of demand, CEOs are taking another look at cutting costs and paring payrolls. Investors, meanwhile, are reassessing their portfolios and dumping shares. If the Fed is not careful, this double-barreled barrage of bad news could crimp the confidence of consumers, the one sector of the economy that has stayed strong and kept the U.S. out of recession.

Almost no industry is immune to the need to chop costs. On Aug. 17, Ford Motor Co. said it would eliminate as many as 5,000 salaried employees by yearend and warned of more cost-cutting to come. On Aug. 21, that was followed by news of up to 1,100 job cuts at Steelcase Inc., the Grand Rapids (Mich.) office-furniture maker, and 1,700 layoffs by New York media giant AOL Time Warner Inc.

But it's not just costs that are being cut. Prices are being slashed, too. The competition is particularly fierce in high tech, where falling capital-goods orders and mounting inventories have sparked an all-out price war in computers and semiconductors. As a sign of the mounting deflationary forces worldwide, U.S. import prices fell 1.6% in July, their largest one-month decline in 8 1/2 years.

The profit pinch has not gone unnoticed on Wall Street, and analysts are busy marking down their earnings forecasts as a result. According to Thomson Financial's Joseph S. Kalinowski, Wall Street analysts on average expect operating earnings of companies in the Standard & Poor's 500-stock index to fall 13.8% in the third quarter and 1.4% in the fourth. Just two months earlier, those same analysts had been projecting a small decline of 3.5% in the third quarter followed by a rise of 8% in the fourth. Even Wall Street's most fervent bulls are turning more cautious. In a note to clients on Aug. 21, Abby Joseph Cohen, chief investment strategist at Goldman, Sachs & Co., conceded that she had been too optimistic about this year's earnings, but said she still sees shares rising by the end of 2001.

Judging by the action on Wall Street, Cohen is in a shrinking minority. The technology-laden Nasdaq index has plunged by nearly 15% in the past 1 1/2 months, while the more broadly based S&P 500 has dropped 5%. "The conditions are in place to test the April lows," says market strategist Robert Stovall of Prudential Securities.

So far, consumer confidence and, more importantly, consumer spending have held up, even in the face of rising layoff announcements and sliding stock prices. But there are signs that consumers might be about to become more cautious. A University of Michigan poll of consumers in early August found that just 18% of those expecting a tax rebate planned to spend it. The remainder intended to stash the money away in savings or use it to pay down debt. "The tax-rebate impact will be very minimal," says Kurt Barnard, president of Barnard's Retail Trend Report. "People are going to buy what they need."

With fiscal policy constrained, the onus is on the Fed to do even more to fire up the moribund economy. But there are clearly limits on what the central bank is able--or willing--to do. While Greenspan has brushed aside concerns that the rush to cut rates could ignite inflation next year, some of his fellow policymakers are not so upbeat. With unemployment still near record low levels despite the economy's weakness, the Fed hawks are worried that price pressures could build up next year if the Fed eases too much now.

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After slashing rates so sharply in such a short period of time, Greenspan could be forgiven for thinking that his job of piloting a takeoff for the economy was about to become easier. But no such luck. With the U.S. perched precariously between recession and recovery, Greenspan faces more difficult decisions in the days ahead. Let's hope he gets things right. The fate of the New Economy depends on it.

By Rich Miller in Washington with Stephanie Anderson Forest in Dallas, Michael Arndt in Chicago, and bureau reports